These are difficult times for asset management. Here, Stephen Morris assesses the various approaches captives can take to manage their investment portfolios.
In these increasingly challenging times the focus of attention for many captive boards is, understandably, turning towards asset and treasury management. It has become something of a balancing act maximising shareholder returns while minimising counterparty exposure and the issue has shown no sign of abating as many of the traditional homes for a captive’s reserves are now facing increasing scrutiny and uncertainty.
Boards are faced with many tough decisions as they steer a course through the minefield of preserving capital, reducing counterparty exposure and maximising yield. At the same time their portfolios need to remain liquid to ensure claims can be paid as they fall due. Under these pressures, the options available to a board—self-manage the portfolio, appoint an external investment advisor, or identify if retained funds could be better used elsewhere in the group by way of loan or dividend—are frequently mooted.
A self-managed portfolio is frequently considered the easiest option for a simple captive with a modest asset base. The board benefits by retaining full control of the asset allocation and, once cash flow and risk appetite requirements have been determined, can spread the captive’s funds across various institutions to reduce counterparty exposure. By employing a variety of products with varying maturity it can be possible to maximise return. The further attraction is that this is considered a low cost solution.
Bells and whistles can be added by way of an agreed, liability-driven investment policy that sets the boundaries of what can be placed, where and for how long. This should be a long-term financial planning document which sets out the captive’s aims, investment objectives, risk tolerances and restrictions in respect of its investments. It goes without saying that the investment policy should be reviewed regularly to ensure the strategic asset allocation remains in line with the needs of the captive and reflects the ever-changing market place.
For many, however, the disadvantages of a self-managed portfolio outweigh the perceived advantages. Deciding which institutions or products to use is a big responsibility: what may be secure today may not be secure tomorrow, and questions remain over how long a captive’s funds should be tied up. Attractive returns may be available for simple cash deposits locked away for 12 months, but counterparty exposure may then start to play on the mind. In many cases if it looks too good to be true, it probably is.
Identifying who is responsible for monitoring the stability and credit quality of investments can be an onerous task and a lot can happen between board meetings as evidenced by the recent crisis in the eurozone. Finally, there is the problem of what to do when bonds or deposits mature, as the process then starts all over again.
An option for many is to appoint an investment advisor to guide the captive through the troubled waters. The disadvantages outlined previously are sidestepped and instead are passed on to a third party who is specifically equipped to address each of the investment concerns. The pain of establishing investment guidelines, within which the advisor has discretionary powers, is reduced and the board is free to concentrate on its primary objective of insurance-related matters.
Having an expert investment adviser also opens up the possibility of risk being seen as an opportunity rather than a threat. It is recognised as being desirable to include higher returning but more volatile asset classes, such as equities and alternate asset classes, on the grounds that the resulting asset mix enhances the overall return and, in some instances, can reduce risk through diversification.
As ever there is a counter argument. Whom to choose as investment manager? In whom should the board place their trust as a safe pair of hands that will deliver consistent and, as far as possible, nosurprise returns? Naturally an advisor’s track record is an important consideration but so too is their independence. Track records are open to manipulation and may originate in, for example, private wealth rather than the institutional client sector. Equally, a number of the larger advisors may be restricted to offering only in-house products which may not lend themselves to the needs of a captive insurance company. This leaves captives with a tough choice.
The final option to explore is to return surplus cash to the owning structure by way of a loan or dividend. This is attractive as it can reduce the borrowing costs and ensure the most efficient use of capital across the wider group.
Isle of Man matters
Isle of Man-regulated captive insurance companies, when making loans to associates under the current regulations, must take care that the solvency of the captive is not detrimentally impacted. The complication for a captive that wishes to lend a significant portion of its assets back to its parent or associated company is the negative adjustment to its solvency margin calculation under the regulations laid down by the Isle of Man Insurance and Pensions Authority (IPA).
Unless full admissibility is applied for, and granted by the IPA, a captive can lend only up to 25 percent of its total net assets to an associated company without penalty. Any amounts lent in excess of this regulatory ceiling are deemed inadmissible when calculating the captive’s solvency margin, and are eliminated from consideration.
A ray of hope for boards entertaining making a loan to an associated company on the Isle of Man is currently being considered by the IPA. The draft regulation proposes to replace the existing provision whereby application for full admissibility of a loan to an associate within the solvency calculation must be made to the supervisor. This will be replaced with specific qualifying criteria. If those criteria are met, then the corresponding loans are deemed fully admissible and the ceiling is removed. Should this proposed change go ahead it will make loans a much more attractive proposition for boards to consider as part of their treasury management discussions.
Clearly there is no straightforward answer, and certainly no one-sizefits- all solution. Captive boards frequently adopt a blended approach where the assets are managed by way of a mix of the aforementionedapproaches while remaining mindful that the contribution of each component will require constant assessment. Those charged with governance must ensure that the management of the captive’s assets remains at the top of the agenda. In most cases a simple risk analysis will underline the importance of this. Considering the options available— even if they are not executed—is vital, as when markets change, they change quickly. Having a plan B should provide some level of comfort that will help those charged with governance sleep at night.
Stephen Morris is an accountant at Thomas Miller Risk Management (Isle of Man) Limited. He can be contacted at: email@example.com
EMEA, Thomas Miller, asset management, captive, insurance